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Tuesday, June 26, 2012

Back in the early 2000s, the world economy was buffeted with a series of positive aggregate supply shocks: the opening up of Asia, rapid technological gains, and the ongoing liberalization of the real economy in many countries. These shocks expanded global economic capacity and implied higher future economic growth. In turn, there should have been a higher global natural real rate of interest given the higher expected economic growth. These shocks also should have resulted in more benign deflationary pressures that would have kept real wages up in advanced economies.

The Fed, however, did not allow this to happen because it feared the deflationary pressures. It loosened U.S. monetary policy and through the many countries that link their currency to the dollar, it also loosened global monetary policy. Even the ECB and Bank of Japan followed suit to some degree since they were mindful of letting their currencies become too expensive relative to dollar and the all the currencies pegged to it.In short, the Fed'smonetarysuperpower status allowed it to lower global real interest rates below the global natural real interest rate level during this time.1 This was an important part of the global housing boom story and the Bank for International Settlements (BIS) was all over it. It repeatedly told the Fed that its misguided fears of deflation were causing it to create a global liquidity glut. The BIS was spot on during this time.

But that was then and this is now. The global economy is now being hit with negative aggregate demand shocks in Europe, Asia, and the United States. The economic outlook is dim and consequently the global natural real interest rate is depressed and is most likely negative. This time around the Fed, with help from the ECB, is keeping global real interest rates above the natural real interest rate level. In other words, global monetary policy is too tight now. This is evident in the figure below which shows that total current dollar spending for the OECD region is depressed.

The only way for such a drop in aggregate nominal spending to occur is for either the stock of money asset to decline or the velocity of money to decline. Central banks can meaningfully reverse both through better expectation management (e.g.. by raising the expected path of aggregate nominal income and spending). The fact that this has not happened and that OECD nominal GDP remains depressed is thus prima facie evidence that global monetary policy has been too tight.

The BIS, however, seems to be operating from the same manual it used in the early 2000s. It tries to argue that global monetary policy is actually accommodative. From its 2012 annual report:

In the major advanced economies, policy rates remain very low and central bank balance sheets continue to expand in the wake of new rounds of balance sheet policy measures. These extraordinarily accommodative monetary conditions are being transmitted to emerging market economies in the form of undesirable exchange rate and capital flow volatility. As a consequence, the stance of monetary policy is accommodative globally.

How could central bank policy be "extraordinarily accommodative" if measures of the money supply in both the Eurozone and the United States are declining? The BIS is falling for the interest rate fallacy here that Milton Friedman warned us about. Low interest rates only indicate loose monetary policy when they are low relative to the natural interest rate, as in the early 2000s. As noted above, this is note the case now.

Put it this way: does the BIS really think that fall in yields on 10-year treasuries from about 5.25% before the crisis to a low of 1.50% recently has been due to the Fed? It is more likely that global slump can explain most of the drop in yields. The fact that yields have remained so low is, if anything, an indication that monetary policy has been too tight. For were the Fed and ECB to raise expected nominal growth, yields would start rising again.

The BIS calls for monetary restraint are therefore way off. It needs to quit thinking like this is 2002 when global monetary policy was too loose and realize that it is 2012, the fourth year of tight monetary policy. The global economy is a far different beast today and policy makers need to respond appropriately.

P.S.Paul Krugman, Scott Sumner, [update: Ryan Avent,] and Isabella Kaminsky also raise questions about the BIS report. Kaminsky notes that what is really needed are more safe assets, something that U.S. Treasury could provide. I agree with her, but would note that if the Fed were to return nominal GDP to trend then it is likely that there would be far more privately-produced safe assets and thus less need for government securities. See here for more on this point.

1 The "global saving glut" can be understood in part as the global economy simply recycling the Fed's loose monetary policy back to the United States. For all those dollar-pegging countries that were forced to buy more dollars when the Fed eased monetary policy used those dollars to buy up U.S. debt. And they did not want just any U.S. debt, but safe U.S. debt. This increased the demand for safe assets. Since there was a limited amount of public safe debt, the private sector responded by converting risky assets into safe assets (e.g. AAA-rated CDOs). Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.

Wednesday, June 20, 2012

It is with regret that we announce the death of Inflation Targeting. The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2009. That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.

Frankel goes on to argue that nominal GDP targeting is likely to be the candidate to replace IT. It might be a bit premature to say IT is dead, but I do think the flaws of IT--even the flexible version of it--have been made apparent over the past few years. It is time to retarget the Fed.

Information received since the Federal Open Market Committee met in April suggests that economic growth remains anemic. Labor market conditions are weakening and the unemployment rate continues to remain elevated. Household spending and business fixed investment appears to be slowing down. Inflation has moderated in recent months. Long-term inflation expectations remain well anchored.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect a sluggish pace of economic growth over coming quarters as the crisis in Europe, the slowdown in Asia, and the uncertainty over year-end fiscal austerity plans are creating significant headwinds for the economy. These developments along with the economy operating below its full-employment level indicates that further action is warranted by the Committee.

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to begin a new conditional asset purchasing program tied to an explicit growth path for nominal GDP. The Committee believes that nominal GDP should expand to $16 trillion dollars and grow at a 5% annual pace thereafter. To this end, the Committee intends to purchase Treasury and Agency securities every week until this target is hit.

This program should raise expectations of future nominal GDP growth and cause a rebalancing of portfolios that will facilitate a rise in current aggregate nominal spending. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.

Something that many observers miss about the Eurozone crisis is that by doing nothing the ECB is doing something: it is passively tightening monetary policy. Total current Euro spending is falling, either through a endogenous fall in the money supply or through a decrease in velocity, and the ECB is failing to respond to it. The impact of passive tightening is no different than that of an overt tightening of monetary policy. Currently it is tearing the Eurozone apart.

Michael Darda sees this passive tightening by the ECB and is not impressed:

European markets quickly ran out of steam today on news of a Spanish bank recapitalization over the weekend. Part of this may be due to the fact that equity markets already discounted the news last week. Moreover, the ECB took a pass on a relatively costless (in our view) opportunity to surprise to the upside with even symbolic monetary stimulus (rate cut, anyone?). Given the ongoing pressure on Spanish and Italian sovereign debt markets—and the correspondingly level of regional inflation expectations—the Spanish bank recapitalization is highly unlikely to be enough to set the eurozone on a more robust growth trajectory. Indeed, we do not believe additional EFSF/ESM measures will be effective unless they are coupled with a much more accommodative ECB monetary policy (i.e., one that provides for faster euro-area nominal GDP growth). The key here is for the ECB to manage expectations properly. Closed-ended, ad hoc actions that are limited in scope are not likely to bear fruit, as increases in base money get absorbed by falling base velocity. A more open-ended and aggressive commitment to reflationary policies, however, would likely require the ECB to do less with its balance sheet, as market forces would help the ECB ease. Although we believe ECB President Mario Draghi got off to a good start, we are not encouraged by recent statements and the lack of follow-through at a critical juncture for the eurozone.

Passive tightening is fashionable these days. It is being done of both sides of the Atlantic.

Niall Ferguson has jut published some great articles on the Eurozone crisis. They are a great place to get up to speed on this important issue. His first one with Nouriel Roubini starts as follows:

We fear that the German government’s policy of doing “too little too late” risks a repeat of precisely the crisis of the mid-20th century that European integration was designed to avoid.

We find it extraordinary that it should be Germany, of all countries, that is failing to learn from history. Fixated on the non-threat of inflation, today’s Germans appear to attach more importance to 1923 (the year of hyperinflation) than to 1933 (the year democracy died). They would do well to remember how a European banking crisis two years before 1933 contributed directly to the breakdown of democracy not just in their own country but right across the European continent.

Ferguson and Roubini go on to list both macropolicies and structural policies that would help the Eurozone. Structural reforms are important since the Eurozone is a flawed currency union. However, in order to make those structural changes the ECB needs to restore aggregate nominal spending to a more robust levels so that there can be enough time for such reforms.

Sunday, June 10, 2012

[Ramesh] Ponnuru has gulped the Kool-Aid as it were, and he’s joined up with a former Treasury economist David Beckworth (presumably one of the minds behind the dollar’s destruction and resulting crack-up during the Bush years)...

How did he know? I thought the dollar destruction group at Treasury was top secret! Seriously, this is what passes for thoughtful commentary from the hard-money advocates? It is remarkable that Tamny's rant against Ramesh Ponnuru and me would be published in Forbes. It is one of those rare works that is so bad it is good.

Here a few of the ways it is so bad. First, Tamny spends about a third of his article showing the problems with classic Monetarism and then attributes them to us. Apparently, he does not realize we are not Monetarists. It is true we are called Market Monetarists, but this is very different view and a little bit of research on his part would have clued him in on this fact. Market Monetarists do not believe in targeting monetary aggregates, but rather targeting the growth path of nominal GDP. Moreover, we believe market signals such as breakeven inflation, stock prices, and exchange rates collectively provide the best indication of the stance of monetary policy. We take market signals seriously.

Second, Tamny is apparently unaware of the huge literature that shows that gold standard was the key international link that made the Great Depression a global event. He does not seem to know that those countries that went off the gold standard the soonest were the ones with the quickest recovery. The classic on this is Barry Eichengreen's Golden Fetters. A more recent, shorter piece is Doug Irwin's paper on France and the Great Depression. A key problem with the gold standard is that it has a hard time handling money demand shocks. If there is a sudden increase in the demand for money, the money supply cannot quickly adjust to offset it and given sticky prices and sticky nominal debt contracts, output must fall.

Some observers may reply the reason the gold standard caused problems during the Great Depression is because central bankers were not playing by the rules of the game. The U.S. and France, in particular, were not allowing the price-specie-flow mechanism to work. They were sterilizing their gold inflows. Had they not done this the Great Depression may have been avoided. Maybe so. But even if true, this success depends on all countries playing by the rules of the game. Given the lack of international cooperation today, it is hard to believe countries would not cheat again on a modern gold standard like they did in late 1920s

Third, Tamny invokes Say's Law. He does not realize that Say's Law holds in a barter economy, but falls apart in a modern economy when there is monetary disequilibrium.

Fourth, Tamny thinks ECB monetary policy is just fine. He is surprised that we would point out ECB monetary policy only works for Germany. He thinks that if we follow our logic, then we should have independent currencies for each of the 50 states. He does not realize there is an optimal currency area (OCA) theory that explains these differences. This theory says that if the regions under the same currency do not have similar business cycles then there should be some combination of shock absorbers--labor mobility, flexible wages and prices, fiscal transfers--in place for them to handle the problems of doing a one-size-fits-all approach to monetary policy. The U.S. has these shock absorbers in place while Europe does not. For example, hard-hit Florida has received huge federal transfers and it is relatively easy for unemployed individuals to leave Florida for a more prosperous state. This is not true for Italy or Spain. That is a big difference.

There is more, but you get the idea. Again, shocking to see this represent the hard-money view and get published in Forbes.

P.S. Scott Sumner also replies to Tamny. He too had a run in with him last year and took him to the shed.

Friday, June 8, 2012

Nick Rowe likes to remind us that money is the only asset on every market. If the supply of or demand for this one asset is disrupted then every market will be affected. This reasoning implies that monetary disequilibrium is essential for the emergence of general gluts. This crisis has reinforced this understanding, but also has shed some new light on what it means. Specifically, this crisis has shown that what is used as money is far broader than the standard measures of money. The widely used M2, for example, is limited to retail money assets like cash and deposits accounts that are used by households and small businesses. Institutional investors also need assets that facilitate transactions, but the assets in M2 are inadequate for them given the size and scope of their transactions. Consequently, institutional investors have foundways to make assets like treasuries, commercial paper, repos, GSEs and other safe assets serve as their money. These institutional money assets, therefore, should also be considered part of the money supply. When viewed from this broader perspective, the money supply has been depressed during the crisis in both the United States and the Eurozone. It should be no surprise then that both regions are in slumps.

Here are some attempts to measure these broader notions of money. First, from the Center for Financial Stability is the M4 Divisia money supply measure for the United States:

No monetary recovery yet in the United States. What about the Eurozone? Let us first look at the Eurozone less Germany. For this region we use the ECB's M3 simple sum aggregate. This is not quite as broad as M4, but it does include some institutional money assets:

Here too there is a wide gap between the trend and actual money stock. Finally, here is the same M3 measure for Germany:

No surprise here. Germany's economy is doing relatively well and thus we would expect to see better monetary conditions there. This relative stability of the money stock is another reason why Germany is no rush to open the ECB monetary spigot to save the Eurozone. Why disrupt stable monetary conditions in Germany?

So what are the monetary policy implications? The most obvious one is that the Fed and ECB should create an environment conducive to monetary asset creation that would support the return of robust aggregate nominal spending. Since most of the money assets are created by the credit, maturity, and liquidity transformation services of financial firms, policymakers should aim to create an environment conducive to increased financial intermediation. The easiest way for monetary policy to do this is to raise the expected growth path of aggregate nominal expenditures. This would raise expected nominal income growth and the demand for money assets. This, in turn, would catalyze financial intermediation and lead to the creation of more money assets. And of course, the way to raise the expected growth path of aggregate nominal expenditures is to adopt a nominal GDP level target. It is time for monetary regime change!

P.S. Peter Ireland and Michael Belognia have an interesting new paper that shows money still matters for monetary policy. This is bound to get some New Keynesians worked up! From their abstract:

Over the last twenty-five years, a set of influential studies has placed interest rates at the heart of analyses that interpret and evaluate monetary policies. In light of this work, the Federal Reserve’s recent policy of “quantitative easing,” with its goal of affecting the supply of liquid assets, appears as a radical break from standard practice. Superlative (Divisia) measures of money, however, often help in forecasting movements in key macroeconomic variables, and the statistical fit of a structural vector autoregression deteriorates significantly if such measures of money are excluded when identifying monetary policy shocks. These results cast doubt on the adequacy of conventional models that focus on interest rates alone. They also highlight that all monetary disturbances have an important “quantitative” component, which is captured by movements in a properly measured monetary aggregate.

Scott Sumners says the Fed and the ECB could learn something from the Reserve Bank of Australia:

Australia has a 2-3% inflation target and faster trend RGDP growth than the US. That sort of nominal growth would be beyond my wildest dreams for the US. Rather think about how proactive they are. Unemployment is low and inflation is in the sweet spot. But they are easing monetary policy because they see the global slowdown, which for some reason the much more sophisticated Fed and ECB don’t quite comprehend. They aren’t cutting rates because 5.5% NGDP growth is too low, they are cutting rates to make sure that 5.5% NGDP growth happens.

Imagine that, a central bank that gets out in front of economic headwinds. What would it take for the Fed and ECB to start acting like that?

Thursday, June 7, 2012

Imagine a sick child with a parent who only feeds them a scrap of food as they get worse. Also, imagine that the parent's determination of getting worse is not consistent. As a consequence, the poor child remains anemic and never knows with certainty when he is going to get more food. Because the child's expectations of future meals is unclear there is intense mental distress that creates secondary health problems, further weakening the child.

We would all be appalled at such a parent. A far better parent would regularly feed the child and pay special attention until the child is healed. Such a child would find the food, predictability, and unconditional commitment comforting. Such parental love would strengthen the child's healing process, helping the child to heal faster on his own.

The bad parent has a name: the Federal Reserve. The child is the weak U.S. economy and the irregular food is the quantitative easing (QE) programs. The secondary health problems are structural ones like the loss of human capital that emerge in the absence of more systematic, sustained, and aggressive aggregate demand support from the Federal Reserve.

At the heart of the U.S. economy's sickness is an excess demand for money or, equivalently, a shortage of safe assets. The ad-hoc and uncertain nature of the QE programs vastly reduces their ability to meaningfully address this problem. Like the good parent who sets an explicit objective of feeding child until he is healed, the Federal Reserve should commit to buying as many assets as needed until the economy has fully healed. Fully healing would be a return to the pre-crisis trend of nominal GDP. Such conditional large scale asset purchases (LSAPs) would create more certainty about the future path of aggregate nominal spending and better anchor nominal income expectations. Like the love of a good parent causing the child's own healing process to strengthen, the increased certainty from such targeted Federal Reserve actions would cause the market to do much of its own healing.

For example, imagine that Ben Bernanke called a press conference tomorrow and announced that the Fed would start doing conditional LSAPs until the pre-crisis path of nominal GDP level target was hit. This announcement would send shock waves through the markets. Portfolios would automatically adjust toward riskier assets in anticipation of the Fed actually doing these conditional LSAPs. This would raise asset prices and raised expectations of future nominal income growth. Current aggregate nominal spending would quickly respond to these developments, helping push nominal GDP to its targeted path and thus reduce the onus on the Federal Reserve to do LSAPs in the first place. The resulting recovery would both increase the stock of safe assets and reduce the demand for them. In short, the Federal Reserve could provide much more effective (and cheaper) stimulus to the economy by better managing the expected growth path of nominal GDP.

Instead, the Federal Reserve chooses to be a bad parent.

P.S. See Evan Soltas post on Israel's implicit nominal GDP targeting to see the potential for healing the sick U.S. economy.

Is the ongoing weakness in the labor market the result of a large skill-mismatch problem? Many observers think so. David Altig of the Atlanta Fed, however, says based on the evidence the answer is no:

Despite the fact that we see some evidence consistent with skill mismatch, it is far from clear that this issue is the smoking gun that explains the current anemic state of job growth...we have yet to find much evidence that problems with skill-mismatch are more important postrecession than they were prerecession. We'll keep looking, but—as our colleagues at the Chicago Fed conclude in their most recent Chicago Fed Letter—so far the facts just don't support skill gaps as the major source of our current labor market woes.

A far easier explanation that falls out of the data is that there is insufficient aggregate demand. Let me be clear here. By insufficient aggregate demand I mean a lack of aggregate nominal spending created by an excess demand for retail and institutional money assets (i.e. the safe asset shortage problem). This is a problem the Fed could solve through better management of expectations. The Fed has failed miserably here and is therefore indirectly responsible for the labor market weakness.

Recent posts by Mike Konczal and myself provide some of the evidence for the insufficient aggregate demand view. Here are a few highlights from those posts. First, the NFIB's survey of Small Business Economic Trends has consistently reported the number one problem facing firms is not labor quality, regulation, or taxes. It is a lack of sales or demand. If the labor mismatch problem were as important as some make it out to be, one would expect to see labor quality be a bigger concern for firms.

Moreover, if one plots the NFIB's data on the lack of demand against the unemployment rate there is a striking relationship that underscores the insufficient aggregate demand view:

Finally, if the skill-match problem were an important part of the story we would expect to see those with the most current skill set to be fairing better than others in the labor market over the past few years. As this figure from Shierholz et al.(2012) show, however, this is not the case:

Occam's razor tells us that the simplest answer is sometimes the best. That and the lack of conclusive evidence for the skill-mismatch hypothesis indicates that we should probably take seriously the insufficient aggregate demand view.